International real interest rate differentials, purchasing power parity and the behaviour of real exchange rates: the resolution of a conundrum
✍ Scribed by Mark P. Taylor; Lucio Sarno
- Publisher
- John Wiley and Sons
- Year
- 2004
- Tongue
- English
- Weight
- 115 KB
- Volume
- 9
- Category
- Article
- ISSN
- 1076-9307
- DOI
- 10.1002/ijfe.232
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✦ Synopsis
Abstract
According to one strand of the international finance literature, market efficiency implies that the real exchange rate follows a martingale process, in direct conflict with the long‐run absolute purchasing power parity hypothesis, which requires a stationary real exchange rate process. This conflict between market efficiency and long‐run PPP appears as something of a conundrum. We resolve this conundrum by relaxing the assumption of a constant real interest rate differential and analysing the vector equilibrium correction system linking prices and the exchange rate, and draw out the economic intuition of our result. Copyright © 2004 John Wiley & Sons, Ltd.